Oil Prices Surge to 2015 Highs: More Upside Ahead?

Oil prices continued to rally this week as they slowly make up ground that was lost during the devastating plunge that cut them in half over the past year. Last week, global oil price benchmark Brent crude rose to over $65 per barrel, which marked the highest level for Brent since last December. Meanwhile, U.S. oil benchmark WTI, likewise, hit its high for the year as it recovered to more than $58 per barrel. Even as oil prices touch their highs of the year, there is reason to believe that more upside could be ahead.

Why oil prices gained last weekFueling Brent's rise over the past few weeks has been the flare up of tensions in the Middle East. A Saudi Arabian-led coalition has been bombing targets in Yemen after Shiite-linked militants seized control of the capital and forced its president to flee. That escalated regional tensions as it pitted the Sunnis, which make up Saudi Arabia and other Gulf states, against the Shiites, and Iran in particular. In fact, Iran has seen the Saudi-led actions as an issue, which is why it sent a flotilla into the Gulf of Aden to make its presence known. That increased the angst of the oil market as the Gulf of Arden is a key oil supply route as the escalating tensions caused concern of a possible disruption in the oil trade, fueling a spike in prices.

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Meanwhile, oil prices in the U.S. received a boost from signs that oil production in the country would be falling faster than at first thought. Further, low oil prices do seem to be fueling a demand response, which has oil prognosticators increasing their outlook for oil demand in 2015. This eased fears that the glut of oil would be worked off quicker than expected.

Why there could be more upside to oil pricesTensions in the Middle East aside, supply and demand dynamics in the oil market are noticeably starting to tighten. For the second straight week the U.S. Energy Information Administration reported a drop in U.S. oil production. This past week's drop of 18,000 barrels per day suggests that the tremendous decline in the rig count is having an impact on oil output. For example, in the Bakken shale of North Dakota oil companies need to drill and complete 115 new wells every month just to keep production flat. However, in February just 42 new wells were completed, leading to a decline in oil production. If oil companies don't begin to complete more wells it could lead to a significant decline in overall U.S. oil production later this year.

At the same time, demand for oil is growing faster than expected as low oil prices are creating incremental demand. For example, according to the Federal Highway Administration, Americans drove 221.1 billion miles in February. That's 2.8% more miles than Americans drove in February of last year. It also suggests that demand for gasoline this summer could be robust as cheap gas prices, along with the fact that more Americans have jobs this year than did last year, should lead to more miles being driven, which will boost demand for oil.

Investor takeawayOil prices are riding high right now. This is as the oversupply of oil works itself out as oil companies cut investments in new wells below what's necessary to keep supplies flat. Meanwhile, low oil prices are fueling a demand response. This combination could very well bring supply and demand back into balance sooner than the market had expected -- leading to even higher oil prices later this year. Backstopping all of this is the potential for a supply shock from the Middle East, which always remains a wild card in the oil market.